Dollar Thrives in Age of Competitive Devaluations

Jan. 29 (Bloomberg) -- In periods of prolonged economic
pain -- notably the 2007-2009 global recession and the ensuing
subpar recovery -- international cooperation gives way to an
every-nation-for-itself attitude. This manifests itself in
protectionist measures, specifically competitive devaluations
that are seen as a way to spur exports and to retard imports.

Trouble is, if all nations devalue their currencies at the
same time, foreign trade is disrupted and economic growth is
depressed.

A country can intervene directly in markets by selling its
own currency as a way to reduce its value or stop it from
getting stronger. Switzerland has been pegging the franc at 1.20
euros to prevent increases in the exchange value from cutting
into its exports to euro-area countries. In November, South
Korea’s central bank sold won to buy at least $1 billion in
foreign currencies to contain the steep gain in its currency.

Decreasing the value of a currency is much easier than
supporting it. When a country wants to depress its own currency,
it can create and sell unlimited quantities. In contrast, if it
wants to support its own money, it needs to sell the limited
quantities of other currencies it holds, or borrow from other
central banks.

Expanded Reserves

The extent of currency interventions is measured by the
jump in global central-bank foreign-exchange reserves to $10.53
trillion in mid-2012, from $6.7 trillion in 2007, according to
the International Monetary Fund. Switzerland has shown the
largest increase.

Nevertheless, currency interventions have seldom had
lasting effects, as shown by unsuccessful Japanese efforts in
recent years that failed to depreciate the yen.

Easy central-bank policy, especially quantitative easing,
may not be intended to depress a currency, though it has that
effect by hyping the supply of liquidity. Also, low interest
rates discourage foreign investors from buying those
currencies. Prime Minister Shinzo Abe has accused the U.S. and
the euro area of using low rates to weaken their currencies.

“Central banks around the world are printing money,
supporting their economies and increasing exports,” Abe said
recently. “America is the prime example. If it goes on like
this, the yen will inevitably strengthen. It’s vital to resist
this.”

It seems clear, however, that the Federal Reserve’s
objective is to spur U.S. economic growth and increase job
creation, not to depreciate the dollar. Furthermore, Treasuries
and the dollar are the ultimate havens, regardless of Fed
policy.

Still, Abe’s response has been to seek retaliation and to
press the Bank of Japan to pursue “unlimited easing” to restrain
the yen until deflation turns into inflation of about 2 percent
a year. And he has threatened to end the BOJ’s independence,
which it has had only since 1998, if it doesn’t come to heel.
The central bank has complied by raising its inflation goal to 2
percent from 1 percent.

The BOJ forecasts inflation at only 0.9 percent for the
fiscal year starting in April 2014. It’s hard to believe that
staid central bankers who congenitally hate inflation want it to
return, but that is what they must do if they value their
jobs. The Abe government has the supermajority in the lower
house of the Diet needed to override the upper house, and can
appoint a majority bloc on the nine-member BOJ policy board. The
prime minister also has revived the Council on Economic and
Fiscal Policy to further pressure the BOJ.

BOJ Purchases

The central bank plans $113 billion in additional asset
purchases, though not until 2014 and after the current $1.2
trillion program is completed this year. The slower pace of the
new acquisitions may reflect criticism from Europe and elsewhere
of Abe’s overt competitive devaluation plans and the already-curtailed independence of the BOJ.

Abe also plans more fiscal stimulus to revive the
recession-prone Japanese economy, and says he won’t be bound by
the previous administration’s $511 billion cap on government-bond issuance. That will obviously add to Japan’s huge
government debt, and Japanese bond yields are rising in
anticipation.

Regardless of the Abe government’s plans, I continue to
believe that the yield on Japanese government bonds will be much
higher in the long run. Until now, Japan has had enough domestic
saving, from households in the 1990s and from business more
recently, to fund its huge government deficits and still have
money to export. That surplus is measured by the current-account
surplus. Because all but 8.7 percent of government bonds are
owned domestically, interest rates are isolated from global
markets and remain very low, making it easier to finance the
massive public debt, which was 126 percent of gross national
product in 2011, net of intra-government lending.

Yet Japan’s trade balance is now negative and the current-account balance is likely to follow suit. Like export-driven
economies, Japan is suffering as the European recession deepens
and slow growth persists in the U.S. Japan is importing
materials to rebuild after the March 2011 tsunami and
earthquake. It is also importing energy to substitute for the
closed nuclear reactors, though Abe wants to review nuclear-energy policy.

As government bonds mature and are replaced by higher-cost
imported capital, the interest on government debt will
leap. Depending on your assumptions for Japanese government-bond
rollovers, market reactions and BOJ activity, you can get almost
any result you want. But there is a distinct possibility that
the leaping interest rates on Japanese government debt will add
so much to the deficits and debt that an uncontrollable spiral
will unfold. It would take years to roll over a significant part
of government debt at higher international interest costs, but
markets anticipate.

Weaker Yen

In anticipation of Abe’s Dec. 16 election landslide, the
yen started to weaken as investors bid up stocks, envisioning a
much more profitable era for Japan’s exporters. In the first
half of 2012, a total of 51 Japanese companies with heavy debt
and significant exposure to the strong yen went bankrupt, twice
the number in the previous four years. And exports are the key
to Japan’s economy as they rise and fall in step with gross
domestic product. Because Japan is the world’s third-largest
economy, behind the U.S. and China, other countries are watching
and may emulate Abe’s currency-busting plans.

The South Korean central bank said it would look at the
configuration of the economy, especially the crucial export
sector, in reviewing its interest rates each month. Despite weak
commodity prices, the Australian dollar has been strong,
precipitating calls for more monetary ease as manufacturing and
tourism suffer. And China, which has succumbed to immense
foreign pressure to allow the yuan to appreciate only in good
times, still holds the currency flat when times are tough in
order to aid the exports that continue to drive the Chinese
economy.

Brazil’s economy isn’t exclusively export-driven, though it
is commodity-oriented and therefore at the mercy of subdued
Chinese manufacturing. And the Brazilian government has been
doing whatever it thinks is necessary to protect domestic
business, first raising interest rates as inflation and the
economy heated up three years ago, then cutting rates as global
economies cooled, and then taking steps last September to
prevent the real from appreciating after the Fed undertook its
third round of quantitative easing. Brazilian economic growth
dropped to about 1 percent in 2012, from 2.7 percent in 2011 and
7.5 percent in 2010.

Competitive foreign-exchange devaluations always pit one
currency against others. Since competitors often retaliate, no
country wins and all lose because of the disruptive effects of
this dynamic on foreign trade. This model is valid if all
currencies are essentially on the same footing, but it collapses
when one, specifically the U.S. dollar, dominates as the primary
international trading and reserve currency. That makes
competitive devaluations of the dollar difficult.

Dominant Currency

A review of history reveals six characteristics of a
dominant global currency, and the dollar is likely to meet the
criteria in at least five of the six for many years.

Rapid growth in the economy and GDP per capita, promoted by
robust productivity growth: In the last decade, the U.S. has
excelled among developed countries and its emphasis on
entrepreneurial activity and superiority in new technologies
suggest this lead will persist.

A large economy, usually the world’s biggest: With rapid
productivity growth and relatively open immigration, the U.S.
will probably continue in this role. The population is falling
in Japan, a trend that will soon emerge in other developed lands
as well as China with its one child-per-family policy.

Deep and broad financial markets: U.S. stock-market
capitalization is four times that of China, Japan or the U.K.
and is more than three times that of the euro zone. Almost 50
percent of Treasuries are held by foreigners. As noted above,
just 8.7 percent of Japan’s government net debt is owned by non-Japanese.

Free and open financial markets and economies: These
conditions persist in the U.S. but are more fragile in Europe
after the debt crisis. China will probably continue to tightly
control its financial markets and currency, which is anathema
for an international trading and reserve currency. Chinese
leaders are so worried about losing control of the Internet that
they now require users to give their real names when signing up
for online services. Also, illegal information, which can be
broadly defined by officials, must be removed by service
providers and forwarded to the authorities. In China, Big
Brother isn’t just watching, he’s reading e-mail, too.

Lack of substitutes: The rigidly controlled Chinese economy
and financial markets eliminate the yuan as a rival to the
dollar for the foreseeable future. Export-dependent and inward-looking Japan doesn’t want the yen to be a primary global
currency. And the European crisis eliminated the euro for at
least a number of years. The U.K. is a relatively small economy,
which curbs the pound’s appeal, and the solid Swiss franc is now
tightly controlled.

The credibility of the dollar has been strained by its
overall decline since 1985, but still is substantial. The
troubling U.S. current-account deficit will probably shrink as
retrenching consumers moderate imports and U.S. production
becomes increasingly competitive and the nation moves toward
self-sufficiency in energy.

In effect, competitive devaluations will ultimately work
against the U.S. dollar. This will only add to the currency’s
luster as the only haven in an uncertain world.

(A. Gary Shilling is president of A. Gary Shilling & Co.
and author of “The Age of Deleveraging: Investment Strategies
for a Decade of Slow Growth and Deflation.” The opinions
expressed are his own. This is the second in a five-part series.
Read Part 1 and Part 3.)